Digging Into The Layers Of Domestic Debt

Most economists and stock market analysts are finally coming to the conclusion that the United States is in too much debt to jump start a quick economic recovery.   Yet most of the analysis of the US debt levels is still simplistic and misleading.  Digging into the layers of debt within various sectors of the economy is very similar to excavating archaeological layers of the earth.  While some sector debt levels will have to be reduced drastically, others can still be expanded. 

The following chart has been widely distributed now thanks to Henry Blodget at Yahoo Finance, nakedcapitalism and Nouriel Roubini, among many others. It shows the ratio of domestic debt to total US Gross Domestic Product – comparing the total amount of debt outstanding to the gross economic output.  Right now, the amount of debt outstanding is staggering relative to our nation’s economic output.

Source: Ned Davis Research

Click To Enlarge Chart

But the chart is a bit misleading and simplistic.  First, the government didn’t keep official debt figures until the mid 1950s.  You’ll see at the bottom of the chart that data prior to 1946 was “interpolated”.   While I’m sure Ned Davis did their best to make sure the data was accurate, it’s far from clean data.  Second, a large part of the increase in the Credit Market Debt ratio in the early 1930s was caused by the implosion of the numerator – i.e. Gross Domestic Product (GDP) growth fell off a cliff by 40% in the early 1930s.  That accounts for much of the spike in the ratio.  So while the overall idea of the chart is correct – there’s a lot of debt outstanding – the numbers are a bit questionable.

The other problem with simply looking at the total debt is that it doesn’t take into account the other side of the balance sheet – the assets.  Over the past two decades, the level of assets for US Households has increased significantly as a percent of total GDP.  So while Household debt has grown rapidly, so have household assets.  However, that trend is now reversing and if it continues as is likely, it will become an issue.   The absolute level of assets still far outweighs the level of debt as is shown in the chart below. 

 

Source: Bloomberg

Click To Enlarge Chart

Debt is definitely a problem.  The overall level of debt has increased dramatically in all economic sectors which is now weighing on the potential for an economic recovery.  Let’s take a look at the official government data since the 1950s and the various components of that debt to get a better understanding of what we’re up against.  The following chart comes from Bloomberg and shows the total debt levels by sector of the economy as measured by the Federal Reserve.   Remember, the debt levels are shown as a ratio – Debt/GDP.  Therefore, an increasing line means that debt is rising faster than GDP growth and a declining line means debt is declining versus GDP growth.  This data is compiled quarterly and published in the Federal Reserve’s Flow of Funds Report.

     

Source: Bloomberg

Click To Enlarge Chart

The Federal Reserve breaks down debt levels into two broad categories – 1) Domestic Non-Financial sectors and 2) Domestic Financial sectors.  The Domestic Non-Financial sector is further broken down into the following economic sectors – 1) Household 2) Business 3) State and Local Governments, and 4) Federal Government.   The Household debt includes both secured Mortgage Debt and unsecured Consumer Credit, neither of which I have shown on the chart. 

Domestic Financial Debt

Let’s examine the debt levels by category.  First, the largest and most rapidly growing sector has been Domestic Financial sector debt.  As we now know, the absurd increase in leverage by Investment and Money Center banks caused the huge increase in the Domestic Financial sector.    The deleveraging of this sector is currently weighing on the overall market.  As you can see, there’s a long way to go before the debt levels in this sector return to more normalized levels.  

The total amount of Domestic Financial sector debt currently stands at $16.9 trillion.   As of the fourth quarter of 2008, US financial companies have written off approximately $729 billion in debt, according to Bloomberg.   I would estimate that the Domestic Financial sector would have to continue to deleverage either through write-downs, write-offs, asset sales or simply paying down until debt returns to $10 to $12 trillion or 70% to 80% of GDP.   That implies another $3 to $4 trillion in debt deleveraging.  Mind you, I’m not predicting $3 – $4 trillion in write-offs – much of the debt will be eliminated through asset sales, paying down debt and portfolio run-offs.

 

Source: Bloomberg

Click To Enlarge Chart

Household Debt

The second largest sector is Household debt which consists of Mortgage Debt and Consumer Credit.   Household debt currently stands at $13.9 billion or 97% of GDP.  Debt growth in this sector began increasing at an accelerating rate in 1999 and 2000 as the housing bubble began to inflate and as households turned to credit to maintain their lifestyle during the 2001 – 2002 recession.  It’s interesting to note this is the only sector which has begun turning down.  Obviously, the housing bust is largely responsible for the reduction in mortgage debt.   However, after the horrendous holiday retail sales season, I believe even consumer credit has turned down as well.  This is perfectly rational behavior on the part of the consumer.  The economy has slowed, the housing market has turned down and consumers are retrenching.  I venture that until Household debt declines to the mid 1990s level of 70% of GDP, the consumer will continue to pull back.  That implies consumer debt will have to decline $3.9 trillion from current levels.

Source: Bloomberg

Click To Enlarge Chart

Business Debt

The remaining sectors of business and government debt are actually in relatively good shape.   Business debt stands at approximately $11 trillion or 75% of GDP.   While this is high, it’s not much higher than debt levels in the mid 1980s or early 2000s when Business debt averaged around 70% of GDP.    I estimate that over the next several years, Business sector debt will decrease by $1 trillion as companies go bankrupt or decide to pay down debt with cash flows rather than increase dividends. 

 

Source: Bloomberg

Click To Enlarge Chart

Federal Debt

The deleveraging from the private sector is being offset by the leveraging up of public debt.   Luckily for President Obama, Fed Chairman Bernanke and Treasury Head Timothy Geithner, Federal government debt as a percent of GDP is actually relatively low.   Current Federal Government debt as a percent of GDP stands at 40% or $5.8 trillion.  Be aware that this figure is not the $9.4 trillion figure widely quoted as “public debt.”  The $5.8 trillion number does not include State and Local Debt, not does it include debt owed to the government itself, such as in the Social Security Trust Fund.  The amount of Federal Debt actually compares favorably to other developed countries.  For instance, Germany’s debt relative to GDP stands at 60% and other European countries stand at over 100%.  Most amazingly, Japan’s two decade long fight against deflation has increased its level of Federal Debt to GDP to over 160%. 

Source: Bloomberg

Click To Enlarge Chart

The fact that Federal Debt is actually a relatively low percent of GDP partially explains why the US government debt is still considered a “safe haven.”   The US government actually has the ability to continue leveraging up.   If it were to expand its balance sheet to the level of Japan’s, it could borrow over $17 trillion more.    This level of borrowing seems unrealistic but it does go to show that the Federal government does have room to maneuver.   It also explains why, despite the huge deficits projected by the Obama administration, the dollar has remained relatively strong. 

State and Local Debt

The final layer of debt measured by the Federal Reserve is State and Local Debt.  At $16.9 billion, this also seems well under control relative to GDP.  Most states are not allowed to run budget deficits and many governments were aided by the housing boom in expanding revenues.  That spending will have to contract to keep the ratio in line relative to GDP. 

Based on my back of the envelope calculations, I believe Financial, Household and Business debt will be reduced by $8 – $9 trillion over the next decade.   This level of deleveraging would bring debt to GDP levels back in line with the early 1990s.  However, the deleveraging of the private sector will be met by the leveraging up of the public sector.  Lawrence Summers, director of the White House’s National Economic Council, confirmed this week that the government will run deficits as far as the eye can see in order to combat the deleveraging going on in the real economy.  

The implications for stock market investors are rather obvious.  While the consumer retrenches, retail spending will remain weak.  The domestic financial sector will also remain weak as those companies continue to deleverage, impairing profitability and reducing growth.  And while businesses will also see some retrenchment, the balance sheets of many US corporations remain strong.   Companies with strong balance sheets should come out on the other side of this downturn in better shape than ever.  Finally, while unchecked government spending is abhorrent to most every taxpayer, the Federal Government actually has the balance sheet to leverage up.  That should avoid a major crisis of confidence in the solvency of the United States, at least in the upcoming four years.